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By Jason Stipp and Christine Benz | 10-08-2014 12:00 PM

Lessons From Our Bucket Retirement Portfolio Stress Tests

Takeaways include the value of asset allocation, investment discipline, and rebalancing.

Jason Stipp: I'm Jason Stipp for Morningstar. Morningstar's Christine Benz, our director of personal finance, recently did another series of retirement portfolio stress tests, and she has some key takeaways to share with us today. Christine, thanks for joining me.

Christine Benz: Jason, always great to be here.

Stipp: Before we talk about some of the takeaways, let's talk about the stress tests that you performed. This time around, you did three of them.

Benz: We did three of them. We examined performance from 2000-13, and we looked at three different strategies for extracting cash flow from a portfolio. The first was a strict total-return approach. So, we reinvested all dividends and capital gains distributions, and we relied solely on rebalancing proceeds plus a cash component of the portfolio to fund living expenses. That was what we call the strict constructionist pure total-return strategy.

We also tested a more income-centric strategy--arguably sort of a naïve, income-centric strategy in that we let our income and dividend distributions fund living expenses on an ongoing basis. And we let those bounce around a little bit. So, we relied strictly on those income distributions. We didn't go to rebalancing if those income distributions perhaps fell below maybe a 4% withdrawal rate. We just relied strictly on whatever the portfolio was able to distribute. And with this particular portfolio mix, we focused a little more on income-producing investments. With the equity-income piece, for example, we focused on a fund that has a notably high income-distribution rate, Vanguard Equity Income (VEIPX), in that particular portfolio.

The third strategy we tested was a hybrid strategy. Here, again, we used income distributions to fund living expenses. If they fell short of our targeted amount, we look to rebalancing proceeds to make up the difference. The idea was to use that pure 4% rule strategy where we had our 4% of initial withdrawal in year 2000 and then we just inflation-adjusted that dollar amount thereafter.

The only portfolio that had any sort of a cash component was that first strategy--that strict constructionist pure total-return approach.

Stipp: And we'll talk about that cash component as one of the takeaways. But the first takeaway from doing these stress tests is that asset allocation works.

Benz: It really does. Arguably, the period that we examined here, 2000-13, even though the tail end of it was very strong for equities, 2000 would have been a lousy time to retire. You would have retired right into that dot-com bust, recovered in the mid-2000s only to experience that financial crisis, which was even worse. So, it was a turbulent period. But the combination of holding bonds in the portfolio as well as holding some cash in that first strategy, that got us through. We were able to meet our distribution rate, and we were also able to end comfortably above our starting value using all three approaches.

So, the nice thing is, even though investors spend a lot of time noodling over their specific distribution strategy--and in fact, it's very important--if you have a balanced portfolio, I think that gets you probably 90% of the way there when it comes to making your retirement plan work, plus having a reasonable distribution rate helps as well.

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